CLP Beacon - Business Issues and Solutions

Monday, February 29, 2016

Defining Ways to Measure and Manage Risk

In managing a business, the CEO and other C-level executives
develop plans and programs that will generate profitable growth. In developing
these growth plans, there are always elements of risk that may create problems
for the company and may prevent them from achieving its goals. These companies
have to deal with risks and impact on several levels and via several classes of
risk. Each class of risk has different significance.

For example, companies may face risks in the following
areas:

·Business risk

·Technology risk

·Competitive risk

·Regulatory risk

·Environmental risk

·Political risk

·Financial risk.

In some cases, there are norms for measuring risk. Norms,
however, aren’t necessarily appropriate or available for all settings or
purposes. Over time, I will cover each of these risk areas and provide
prescriptions and tools for handling them in various blogs and whitepapers. In
this blog, I want to cover one area of risk which is in the area of financial
risk.

One of the most common risk measures in the financial
services space is volatility of returns, usually quantified as the standard
deviation of returns over a specific time period. Short term risk and long term
financial risk are both measured by volatility. We can look at this in terms of
two specific time frames: daily volatility and long term volatility. The return
volatility, σ, for 100
days works out to be 10 times the volatility for one day. More concisely:

σ100 = (√100) *σ1 = 10 *σ1

We need to be careful here, as there is an implicit
assumption that those daily return values follow a normal distribution. (You
recall that bell-shaped curve that describes a normal distribution from
statistics class, right?) This often isn’t too unreasonable as an assumption in
“normal times” for many financial returns. But it may well be reasonably heroic
in unusual times like those of today. Let me share an example from one company
with which I worked.

For a number of years, I worked as head of risk management
and chief compliance officer for a globally regulated firm that managed
currency risk (a component of financial risk) for institutional investors from
all over the world. This company used “risk of loss” as the metric of financial
risk. The natural follow-on questions are how does one define risk of loss and
how does one measure it accurately?

The definition of risk of loss is exactly what the words
say: by being exposed to the risk, one will lose in the event the outcome is
adverse. Conversely, one will gain
when the outcome is favorable.

In order to measure risk of loss, one has to be able to measure
and quantify two components:(i) exposure to the risk, and,

(ii) the
probability of occurrence of adverse moves.

In the context of currencies, exposure is simply the
difference between the value of the underlying assets in local currency terms
(e.g., the Yen value of a portfolio of Japanese stocks) and the magnitude of
any hedge currently in place.

More concretely, suppose a manager has an international
portfolio of stocks for a US pension fund. The value today of the Japanese investments
is, say, JPY 10 billion, or about USD 90 million if the exchange rate yen is roughly
JPY 111 = USD 1.

An equity portfolio manager typically does not forecast
changes in exchange rates but rather attempts to outperform the Japanese equity
market by selecting stocks expected to outperform the market. In order to
protect the USD value of the portfolio, that equity manager might elect to
hedge most of the currency exposure. By so doing, the risk level and impact of
currency risk can be reduced. For example, the equity manager can sell forward
say, JPY 9 billion to reduce the currency exposure by 90%. This means that if
JPY increases relative to USD, the portfolio will only gain translation value
on 10% of the portfolio as the manager, by dint of the passive hedging tactic,
locked in the lower value with the hedge, i.e. the hedge will incur a loss.
Conversely, if JPY falls relative to USD, the portfolio will only lose on the
10% exposed to currency movements.

The risk and impact may be charted as follows. This figure
shows the initial risk-impact (H,H) and how, through the hedging tactic, “sell
currency forward” the risk and impact both are reduced to a more tolerable and
acceptable level, (M,M) as indicated by the direction of the arrow.

Now for the second part: How can one accurately assess the
probability of an adverse outcome? To do this the firm had a model for the
daily returns of currencies. The model did not, however, assume that currency
returns follow normal distributions. Rather the model assumed a more flexible
distributional form which allowed for skew in the distribution of currency returns.
By doing this, the model could accurately assess the likelihood of adverse
exchange rate movements. Given this assessment, which was updated daily,
exposures to each of the currencies in an international portfolio could be
adjusted to keep the probability of loss in an acceptable range. This allowed
for the exposures to be adjusted in order to take advantage of favorable
changes in exchange rates and reduce exposures when adverse movements occurred.

Rather than passively hedge a portfolio’s foreign currency
exposure for some period of time, exposures could be actively managed. This was
all made possible by choosing a more appropriate risk measure – here, risk of
loss – and then actively managing the foreign currency exposures as described
above. Overall the result of the hedging program tended to add value relative
to a passive hedging program.

This is but one type of risk management as this blog focused
on a financial, i.e. currency, risk. It shows that one must think carefully, and
even creatively, about the risk metrics that one uses in a particular setting.
While a risk metric may be definable and calculable, it may serve no useful
purpose and potentially blind those using it to very real risks or even
opportunities to add value.

C-Level Partners helps companies grow their revenues and
improve margins while managing risks and impacts. We believe these components
must be designed as complements as part of a total growth system. If you would
like to discuss your company’s specific business issues feel free to contact me
on bnewton@clevelpartners.net.
And if you like this blog and find it useful, please like it and share it with
others.